Tuesday, May 6, 2008

How to judge an Investment ...

Quote of the week:
"When the Fed is worried about the state of the economy, it basically responds by printing more of that green paper, and using it to buy bonds from banks. The banks then use the green paper to make more loans, which causes businesses and households to spend more, and the economy expands. This process can be almost magical in its effects: a committee in Washington gives some technical instructions to a trading desk in New York, and just like that, the economy creates millions of jobs. But sometimes the magic doesn't work. And this is one of those times." - Paul Krugman in the NY Times.

A carefully chosen, selective misquote. Just in case you didn't believe those of us who have said that the overleveraged financial system doesn't really work.

Commentary for the Week:
How to judge an Investment ...

Judging whether something is a good investment for your hard earned money is a skill that is critical in importance but seems to be in quite short supply. Especially from the way the markets have developed in the last year, it is obvious that with the exception of some truly good asset managers, most financial types that portray themselves as experts are quite clueless. They get away with this because their clients, us, are equally unsophisticated when it comes to financial matters. This is compounded by the complexity of our economy, which ensures that people who are geniuses at their non-financial jobs, turn to mush as soon as they begin to discuss their finances. In order to rectify this problem as much as one can, here are my humble suggestions for a few characteristics one should look for when judging the quality of a potential investment.
Most investments can be judged according to 5 fairly straightforward criteria. A perfect investment for you would be one in which all 5 qualities of the investment match perfectly with your particular needs. Also, there is no such thing as a perfect investment (perhaps because Ittihad hasn't developed one yet, and if we can't do it, I am sure you know that other's have little chance). More seriously though, even a 'perfect' investment will require you to make tradeoffs because sometimes the criteria work against each other - so you can have some of one and some of another, but not all of all. Anyway, good criteria against which investments should be judged are:

1. Income: Does the investment provide you with regular income?
2. Growth: Will the investment grow over time? Will it grow to what you want it to grow to? (Infinity is NOT a good answer here)
3. Liquidity: Will you be able to sell the investment quickly for a fair price if you have to sell in a hurry?
4. Safety: Is this a safe investment? Is your principal protected in some way? Will the investment be volatile?
5. Responsibility: Will your investment harm society or will it be beneficial?

Usually, you can find an investment that performs decently in maybe two or three criteria. A real estate investment for example, can provide you with rental income, some growth and some safety. But you cannot sell a house efficiently for its full price in the middle of February for example. Similarly, mining exploration stocks can provide you with a lot of growth if the companies in question find resources, but the environmental damage of a mine and the lack of safety keeps most investors away. This is all fine and dandy you say, for simple investments such as stocks and houses, but how would this model work for complex derivatives such as CDO's, you ask? Well, let's try - and then you can be the judge of whether the model can help you the next time someone tries to sell you something that is the 'Best Thing Since Google'.

CDO - Collateralised Debt Obligations (of subprime fame)

1. Income: Yes, they provided higher income than Bonds of similar credit rating (this rating was found to be problematic later but let us imagine that we are not judging in hindsight).
2. Growth: Absolutely Not. Growth was usually quite limited through embedded call options that allowed the seller to buy them back if they started increasing in price.
3. Liquidity: Yes, the promise of liquidity was always there (even though in practice it turned out that nobody wanted to buy the things)
4. Safety: Yes and No. Credit rating suggested yes. Exotic nature of products suggested that safety was lacking. Definitely not an unqualified Yes.
5. Responsibility: Extremely Irresponsible. Loan products do not add benefit to the economy, they add debt, which has to be repaid at a much faster increase than the rise of wages. Also, the introduction of complexity for the sake of hoodwinking investors is hardly an ethical practice.

I think it is safe to say that the model has some potential. If you begin to apply it with discipline to the things that you are thinking of buying for investment purposes, it might help bring out some features of the investment that are not-so-shiny under that gloss. In other cases, it might actually show you how good a potential investment really is, just the way it happened here at Ittihad this morning. But then saying anything more would be telling ...

Finance News:

1. The Storm before the Lull? ... The Dow climbs 400 pts in one day ... If it takes $200Billion of free money to buy you 400 pts ... how much to break the Dow Record? ... read more here

2. This is priceless ... The notorious Carlyle Group (of elder Mr. Bush fame), leverages its initial capital 32X (this means borrowing an amount 32X larger than one's own equity) for one of its investments ... with somewhat predictable results ... read more here

3. Say hello to the 40-Yr Mortgage. Home affordability the lowest it has been since 1990 ... read more here

Economic News:

1. Investors looking away from US$ investments ... the question to ask your broker / financial advisor is - how much of my retirement savings is invested in the US? ... read more here

2. The CDN federal government proposes changes in immigration policy ... may have grave effects on economic growth ... less capital inflow / less housing demand = lesser growth ... read more here

3. S&P says that the market panic is almost over ... 'pure hogwash' - as they say in the land below us ... read more here

4. Why the Fed's recent actions might fail to produce a recovery ... read more here

Islamic & Middle East Finance:

1. All the 'Islamic' countries of the world have gotten together to build an anti-poverty fund (which is less than 1/6th the size of the Bill and Melinda Gates Foundation) ... well, it's a start ... let's see how they help the people they say they want to help ... read more here


1. Essential advice for Small and Medium business - owners from the Harvard Business Review ... read more here

2. Yet more entrepreneurial advice ... from a more personal perspective this time ... read more here

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